Volatility and Inflation – Market Commentary – Q1 2023

Currencies, banking system (SVB, CS), volatility and inflation have kept markets on edge. Regarding inflation [1], central banks have consistently maintained that it would subside quickly, and they appear to have been correct. Inflation is generally slowing down. However, in some countries, inflation rates remain exceptionally high—March inflation in the UK exceeded 10%.

The aggressive U.S. stance on interest rates and the threat of “banking contagion” shook stock markets. However, these fears were quickly alleviated by central banks, which reassured investors that banking systems remain robust.

The Federal Reserve’s continued fight against inflation still positions the U.S. dollar as a safe-haven currency, although 2023 has been a volatile year for the dollar against most currencies, including the Canadian dollar.

How Currency Volatility Influences Markets

In Europe, the euro fluctuated between a high of 1.10 USD and a low of 1.052 USD during the quarter, recently trading just below 1.10. The British pound peaked at 1.24 USD and bottomed out at 1.18, while the Canadian dollar reached a high of 0.7525 USD (1.3275) and a low of 0.7215 USD (1.3860).

The International Monetary Fund (IMF) forecasts a recession for the UK in 2023 while improving its growth outlook for the U.S. economy and the eurozone. Canada, with a projected economic growth of 1.5%, is also expected to avoid a recession.

After reaching 40-year highs in 2022, inflation now appears to be declining naturally. However, it’s important to note that in a major economy like the UK, inflation remained in double digits in February, prompting the Bank of England to raise interest rates to 4.25%.

Regional Analysis: United Kingdom, Eurozone, United States, Canada

UNITED KINGDOM

The Consumer Price Index (CPI) decreased less than expected, from 10.4% in February to 10.1% in March. Persistent high inflation continues to push the Bank of England (BoE) to raise interest rates. Markets anticipate a 25-basis-point increase in May. Recent economic data suggests the UK might avoid the IMF’s predicted recession. The BoE still expects consumer price inflation to decline throughout 2023 and fall below 2% by the end of 2024. But economic forecasts don’t always play out as expected…

EURO ZONE

The European Central Bank (ECB) raised interest rates by 50 basis points in March after an unexpected inflation surge in February. However, subsequent reports from major eurozone economies in March indicated a decline.

Eurozone inflation fell from 8.5% to 6.9%. In Germany, it dropped from 8.7% to 7.4%, with similar trends in France, Italy, and Spain. Will the ECB reconsider its interest rate stance given these recent figures? For now, the ECB has announced further rate hikes, which could keep the euro strong.

UNITED STATES

The U.S. economy benefits from a stronger-than-expected labor market and other positive indicators. Core inflation declined from a peak of 6.6% last autumn to 5.5% in February. The Fed raised its interest rate to 5%.

This marks the second consecutive 25-basis-point hike, signaling a slowdown in the pace of increases. It could indicate a shift toward a more cautious rate policy.

Politically, the question of who will challenge Biden in 2024 remains a significant unknown. The U.S. debt ceiling debate (June) could impact the dollar’s status as the world’s reserve currency and weaken it. Although the Fed raised rates to 5%, the dollar weakened against the euro and pound, while the Canadian dollar approached its 0.75 USD high. U.S. interest rates are likely to peak at 5.25% this year before falling to around 4.25% by 2025.

CANADA

CANADA Inflation in Canada continues to decline, while expectations of further U.S. Fed rate hikes grow. Recent Canadian CPI data suggests the Bank of Canada (BoC) will hold interest rates steady at 4.5%. Falling inflation indicates that the BoC’s restrictive monetary policy is effectively curbing price pressures.

CENTRAL BANKS

Central banks worldwide have aggressively raised interest rates, bringing them back to pre-financial crisis levels. Their goal is to tighten liquidity, reduce demand, and drive prices lower—and it seems to be working. They want to prevent a situation where producers pass costs onto consumers, triggering a wage-price spiral.

So far, they appear to be succeeding in many countries. Despite a brief inflation surge in February, most central banks still forecast inflation will end 2023 at a lower level than today. Upcoming central bank meetings will be crucial to monitor.

Currency Forecasts and Exchange Rate Risks

At D-Risk FX, we believe exchange rates behave stochastically and are therefore unpredictable. We consider currency forecasts to be speculative, and no major financial decision should be based on them. A proactive risk management approach, such as the one provided by D-Risk FX, is far more suitable for businesses exposed to currency risk.

Observed Variance Across Currencies (Max-Min) – Q1 2023

Nevertheless, as illustrated in the above table, using the high and low exchange rates observed in Q1 2023, one can see how currency risk can significantly impact a company’s profitability. The discrepancy between financial institutions’ forecasts often exceeds these observed fluctuations. If your expected net profit on a euro transaction is CAD 150,000, more than 40% of that profit could be at risk due to exchange rate variations [2]. That’s too much to leave to unpredictable currency forecasts.

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[1] See the Bank of Canada article: Inflation explained

[2] See: What is meant by the extent of risk?

For more information, check out the following articles: Volatility and Inflation: Interest Rate Hikes or Inflation Under Control? , Volatility and Inflation in a Context of Economic Growth and How interest rates affect inflation?

International Markets: A World of Opportunities

Developing business abroad is a source of growth but carries risks for SMEs. The risk of currency fluctuations is one of the significant factors of success or failure internationally because it can quickly become complex to monitor the successive impacts of exchange rates on the anticipated performance of the company in order to support its profitability.

With D-Risk FX track the performance of each market and business line continuously while considering your hedging strategies.

Approach these markets with the security of a clear exchange rate risk management strategy and monitoring that matches your ambitions.